Source: http://www.riskandinsurance.com, March 25, 2014
By: Dan Reynolds
Risk Scenarios are created by Risk & Insurance editors along with leading industry partners. The hypothetical, yet realistic stories, showcase emerging risks that can result in significant losses if not properly addressed.
Disclaimer: The events depicted in this scenario are fictitious. Any similarity to any corporation or person, living or dead, is merely coincidental.
Hal Landis walked into the boardroom at Stratton Bank headquarters in Chesapeake, Va. with a glow building inside of him.
The chairman and CEO of the bank, he carried in his briefcase paperwork that detailed the possible acquisition of Stratton by Manhattan-based Global Corp.
Global Corp., with about $100 billion in assets, liked the look of the mid-sized Stratton, which held about $30 billion in assets.
With its roots as a lender to the conservative farmers and fishermen of the Middle Atlantic, Stratton had a reputation for producing modest, steady returns and never taking unnecessary risks.
“Shall we get started everyone?” Landis said with a confident grin.
At 63, Landis was in good shape physically and financially, and with what Global was offering on a per-share basis, he couldn’t help but fantasize about the sort of retirement he might now be able to afford if this deal went through.
Two hours later, the rest of the board of directors was won over. They voted to accept Global’s offer, conditional on the approval of that corporation’s board of directors.
The Global board meeting to discuss the Stratton acquisition did not go quite as smoothly.
The audit committee had barely completed its report on Stratton’s financials when Augie Desmond, a junior staffer in the bank’s risk management department, spoke up.
“Mr. Bedford,” Desmond began, addressing the bank’s chairman, the formidable Alan Bedford.
Eyebrows were raised. It wasn’t common for junior employees to punctuate Global meetings with unsolicited remarks or questions.
“Nice working with you kid,” the CFO said to himself.
“Yes, Mr. …” Bedford began.
“Desmond, sir, Augie Desmond, from risk management,” Desmond said.
“Yes, Mr. Desmond?” Bedford said, throwing a questioning look at Desmond’s boss, CRO John Fairmount.
“I have serious concerns about this acquisition, sir,” Desmond said.
“There was a piece in the Journal today on a steam-generating solar plant in Nevada,” Desmond said.
Fairmount shot Desmond a look.
“Sorry John,” Desmond said. “I didn’t have time to tell you.”
“According to a report from Stanford, the heat from the plant is killing wildlife — lots of it — including the state bird,” Desmond said.
“Wha….?” Bedford began.
“The solar company, Daedalus, is based in Virginia,” Desmond said. “Stratton is the primary advisor on the company’s upcoming IPO. Daedalus is applying for a second permit, an even bigger plant with about $30 million in investment. If the politicians get hold of this thing, and they will …”
“What thing?” Bedford said.
“The bluebird thing sir, that’s the state bird. If this second plant application goes south, that solar company is at serious risk and so is Stratton — I don’t like it sir … I don’t like it one bit.”
“Mr. Desmond what is your background?” Bedford asked.
“I have a Master’s Degree in astrophysics from MIT,” Desmond said.
“And how long have you been in the banking industry?” Bradford said.
“Three months sir,” Desmond said.
“I’ll take that under advisement,” Bedford said.
Without much further debate, they followed the recommendation of the audit committee and approved the Stratton acquisition.
The meeting of the Stratton Bank stockholders to vote on the approval of the Global Corp. offer was held in the conference rooms at the Chesapeake Madison Hotel. Before the vote, the floor was opened up for discussion.
As he was at every meeting, Smitty Ackles, a shareholder and crabber from Havre de Grace, was first to the mike.
With his enormous gut protruding from between the bands of his cherry red suspenders, Ackles stood at the mike, smiling with wizened eyes at Hal Landis.
“Good afternoon, Mr. Landis,” Smitty said.
“Good afternoon, Mr. Ackles,” Landis said in what the audience recognizes as their standard opening schtick.
There are chuckles throughout the room.
“What I’d like to know, Mr. Landis, is why in the world the shareholders should accept this deal? We have been doin’ alright for 35 years, nobody’s complainin’ about their returns. Why do it?”
“Well, a 20 percent premium on our shares is one reason,” Landis said.
“Not worth it,” countered Ackles. “These boys from New York will bring more trouble than they’re worth, I guarantee you.”
“I’ve known you since you were a boy, Hal Landis, and I’m here to tell you, you’re making a mistake,” Smitty said before ambling away from the mike.
There are more chuckles, but nobody really listens to Smitty. Stratton shareholders approve the deal 2,010 to 15.
Not even a week later, the Nevada Department of Environmental Protection issues a surprise ruling that condemns the second Daedalus plant.
A study from the University of Nevada confirms what the Stanford researchers found. The plant is linked to the deaths of 1,000 Mountain Bluebirds, the state bird. Deaths of other birds number in multiples of that.
Geddy Hayes, an influential Nevada State Senator from Sparks, picked up the football and ran with it. Hayes, a gifted speaker, worked his magic from the Senate floor and killed any remaining chance the second Daedalus plant had.
The application for the plant, which the solar company spent millions on, went under.
Hayes wasn’t done with Daedalus. He pressured state regulators into burdening the existing plant with new regulations — to the point that it began to lose money.
On a Monday afternoon, Hal Landis sat in his office with CFO Dylan Reed, watching a cable news financial report.
The Daedalus IPO launched the previous week and did fairly well, with the share price rising 17 percent by week’s end. The following week was a different story.
Losses suffered by the Daedalus plant are being reported, along with the losses from the failed application for the second plant.
One week after the IPO launch, Daedalus shares are down 30 percent and are in freefall.
“How bad do you think this is for us?” Landis asked Reed.
“I don’t know, I’ve never been in this position before,” Reed said.
“None of us have,” Landis said.
Within two days, Stratton is set upon in a class action by attorneys for disgruntled Daedalus shareholders, who report millions in investment losses.
The acquisition of Stratton by Global is set to close in the third quarter. In its second quarter financials, Stratton reports a multimillion dollar write down in connection with the Daedalus fiasco.
Weakened by the reputational hit of the Daedalus shareholder class actions, Stratton also begins to notice some alarming revenue declines.
This time, at the Global board meeting where the decision to follow through on the Stratton acquisition will be made, it’s Augie Desmond’s boss, John Fairmount, who speaks first for the risk management department.
“Mr. Bradford, it’s our opinion that we should absorb any frictional costs and abandon this acquisition,” Fairmount said.
“Based on what data?” asked Global’s CFO, Daniel Silberstein, who championed the acquisition from day one.
Fairmount turned to Desmond.
“We’ve run an algorithm that ties share price to reputational damage. Call it a reputational risk index, if you will,” Desmond said.
“Based on what we’re seeing with Stratton, we see share price deterioration tied to reputational problems plaguing the bank for at least the next six quarters,” Desmond said.
Bradford shot Fairmount a look that said, “Again with this kid?”
Bradford and Silberstein aren’t swayed. They like Stratton’s basic book of business a lot. The bank hasn’t had a quarter in 20 years when it didn’t return a dividend.
Global’s board votes 13 to 4 to go ahead with the acquisition.
In the first six months following the acquisition year, Stratton shows a revenue decline of 20 percent over the previous year.
The solar deal in Nevada that went sour is poisoning the bank’s brand with its largely conservative retail banking customers.
A sizable chunk of Global shareholders are fed up. Rather than start an internecine war with their own management, they take action against Stratton.
The allegations are that Stratton failed to disclose the risk of the Daedalus exposure to the Global board and bungled the crisis management of the failed IPO.
Two years ago, if you’d asked Hal Landis who his insurance broker was, he couldn’t have told you. Now he knows him very well.
“You have $10 million in general liability coverage,” the broker explained to Landis over the phone.
“Right,” Landis said.
“Between the Daedalus IPO shareholder actions and the Global shareholder actions, you’re looking at $15 million in potential liability,” the broker said.
“Do you see any indications that your own shareholders could take action against the board?” he asked.
“Not to date,” Landis said.
“You have that much in your favor,” he said. “For the time being.”
“Well, we can self-insure the $5 million on top of the policy if we have to,” Landis said.
“Sure,” the broker said. “But I can’t think of an admitted carrier who will even talk to us next year.”
“What’s an admitted carrier?” Landis said.
“It’s a carrier who’s not going to charge you your right arm in premium,” said the broker.
No longer fantasizing about a rosy retirement, Landis wonders how long he’ll have a job.
Risk & Insurance partnered with Aon to produce this scenario. Below are Aon’s recommendations on how to prevent the losses presented in the scenario. These lessons learned are not the editorial opinion of Risk & Insurance.
1. Risk management requires an open mind: Ignoring stakeholders that voice legitimate concerns carries a double-edged risk. The first risk is the magnitude of the exposure brought up by a colleague or shareholder that’s being overlooked. The second is the fact that an issue was raised publicly, thereby documenting a concern that went unheeded by management.
2. Risk by association: Operational risk is such a pressing risk for financial institutions in part because of the number and variety of business partners and clients they take on as part of their basic operation. An inadequate knowledge of the technology, practices and risk exposures of any given business partner can result in reputational and other damages should that business partner fail or incur a sizable liability.
3. Transparency: Companies that fail to properly assess their risk and report it to business partners face increasingly painful regulatory sanctions. A blunt assessment of an organization’s exposures is the first step in that process. Being forthright in communicating risk factors is the second.
4. Analyze cover: Regulatory pressures and a rapidly changing business environment necessitate that financial institutions assess their insurance coverage more frequently than ever before.
5. Risk management is a process, not a program: There is nothing static about risk management. New processes, products and distribution channels in the financial services industry mean that the nature of operational risk is changing constantly. Risk management needs to keep pace with that change or risk losing relevance and value.